Challenger Technologies Limited's (SGX:573) robust earnings report didn't manage to move the market for its stock. We did some digging, and we found some concerning factors in the details.
A Closer Look At Challenger Technologies' Earnings
In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.
As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.
Challenger Technologies has an accrual ratio of -0.25 for the year to June 2021. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of S$32m in the last year, which was a lot more than its statutory profit of S$22.9m. Challenger Technologies shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Challenger Technologies.
How Do Unusual Items Influence Profit?
While the accrual ratio might bode well, we also note that Challenger Technologies' profit was boosted by unusual items worth S$8.1m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. We can see that Challenger Technologies' positive unusual items were quite significant relative to its profit in the year to June 2021. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.
Our Take On Challenger Technologies' Profit Performance
Challenger Technologies' profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, it's hard to tell if Challenger Technologies' profits are a reasonable reflection of its underlying profitability. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For example - Challenger Technologies has 2 warning signs we think you should be aware of.
In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there are plenty of other ways to inform your opinion of a company. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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